Friday, December 31, 2010

Options as a basic life skill

There are frequent calls to include personal finance topics as an essential life skill that should be taught in high school.  I'd suggest that options topics are important life understandings as well.  These include:

The legal concepts and of obligations and rights.  Essential to understanding any contract.  Options are the simplest form of rights and obligations triggered by a (hopefully) simple measurable event.
The equivalency of short puts and calls to buy and sell offers, and the advantage of doing so if the offer has relative permanence.
The equivalency of owning an asset with a long call and short put position.

The ability to understand this last point of option equivalencies to assets and financial instruments, is key to understanding alternative financial instruments including natural finance.

A corporation is fundamentally a call option (with unlimited duration, strike price of 0) given by bond holders and other debt holders to shareholders.  Shareholders are entitled only to surpluses above and beyond the full repayment of bond holders.  Through bankruptcy legislation and process, bondholders effectively hold a put option (unlimited duration strike price of somewhat indetermined less than zero) given by shareholders for taking over the company in event of insolvency.

Options can create value out of thin air.  Someone who owns a stock currently valued at $50 can decide to sell it if it reaches $60, and not sell it if it drops to $10.  By writing an option with strike price of $60, the stock owner has the exact same risk profile as his current attitude, but is paid to keep it.  The buyer of the option gains all the benefits of the stock rising above 60, with no risks of it dropping far below $60.  If the option writer is indeed paid to do something he would have done anyway, the value creation is entirely captured by him, though the buyer voluntarily pays what is a fair price to him.

Insurance also has strong options analogies.  A policy holder who has replacement value coverage for an asset holds a put option on that asset at strike price of the replacement value less deductible.  It isn't quite a pure option in that the rights to exercise are convoluted, and can be objected to by the insurer.  In fact, when replacement value is well above market value of the asset, trying to exercise the policy holder's put is likely to arouse suspicions of insurance fraud.  Alternative insurance structures could create value by reducing the put's strike price.  It would lower premiums, and increase trust by both insurer and insuree by lowering suspicion of fraud if there is a claim.

Progressive taxation can also be seen as a series of call options you have been made to grant to the government/society.  Progressive taxation is widely accepted as inherently fair.  The argument for it is that those who extract the most value from society should repay society more than those less fortunate or able.  Resulting income equality staves off social unrest.  The interesting aspect of these options obligations is the relative complacency those involved have towards ever increasing taxation obligations on marginal income.  2 factors explain this complacency.  First, psychology makes you more docile about payment when it is based on success and you can afford it.  Second, we universally prefer trading off fixed risk for less potential ultimate reward.  A flat $10K per US adult in taxes would not pass democratic approval regardless of republican PR capabilities.  Offering an increased share in our success is an attractive trade to lower the chance of destitute bankruptcy.

This later concept, of universal preference for trading off risk and certainty for return,  forms one of the basis for using capped queued soft loans in natural finance.  When buying a security, issuing the seller a call option at double the purchase price is unlikely to meaningfully affect the transaction's price or attractiveness.  The cap also serves to self-mitigate greed and desperation at time of financing, and enhance the predictability of investor returns.

The importance of options as a financial engineering instrument is its design to compartmentalize and subdivide risk.  The insurance analogy transfers risk from those that can't afford it (policy holders) to those who can diversify the risk among several policies.  All value creation through financial engineering is through either risk reduction or trust enhancement.  Natural Finance focuses on both these forces to design enterprise structure and financing.  Understanding natural finance, depends on understanding options.  Understanding options also enables understanding financial engineering and solutions in general.  A population that is educated in these matters is better able to participate in financial solutions, and hopefully understand and defend against predatory financial propositions.  Whether finance concepts best belong at a high school level, or treated as a liberal arts undergraduate compulsory, strengthen a nation's intellectual and economic capacity.

Sunday, December 12, 2010

Environmental consciencious choice is the cheapest choice

Crude oil burning is considered a main contributor to global warming and destined to melt icecaps that will flood and kill 100s of millions of people.  It also damages air quality, and is a scarce resource which needs to be diversified from.  While humans have a collective incentive to minimize such huge costs through simple and obvious national taxes on oil and gasoline to curb and shift demand to other sources of energy, sects of people can profit substantially from drill baby drill, and burn it baby burn it.

Environmentalism can confuse and oversimplify "all oil based products are bad".  First, oil is extracted for its gasoline, kerosene, diesel and heating fuel contents.  Oil refining separates these components out of crude oil.  Plastics are produced from a lesser byproduct of fuel extraction.  Since plastic does not emit greenhouse gases (I'm not positive to what extent that is true), and is essentially produced from permaculture/recycling principles on oil, vilifying plastic on anything but its potential carcinogenic properties has the same tenuous misplaced objection as vilifying leather for the murder of suboptimal calorie and protein production vehicles.  Both are mere byproducts of industry that persists without the byproduct existence.

Polyester and spandex are oil based plastics.  Cotton is a natural renewable plant based fiber.  Cotton's price has spiked substantially recently.  Cotton production displaces food production, and price spikes cause it more-so.  I don't believe there is a morality argument when choosing between cotton and polyester.  Rather purely a choice on fiber value.  A natural fiber's only benefits is that health properties have had millennia to be investigated/understood and non-toxicity can be more safely presumed.

Hemp and bamboo are prodigious plants capable of supplying vast amounts of textile and wood materials.  Strength and weight properties make these materials suitable for even bicycle frames.  They are not so perfect as to replace all wood and textiles, though they certainly have superb ecological properties, and deserve promotion on those grounds.  Other woods grow more easily in certain locations, and as a result of past investments, are harvested and processed in large scale, and are closer to North American markets.  The most ecological choice short term is to use what is available near by, now, and most cheaply.  Shipping small batches of bamboo product from Asia is economically disadvantaged because it is economically and ecologically expensive to transport.  It is thus important to understand bamboo as having long term ecological sustainability while realizing that today's ecological choices remains today's local economic choice.

Wikileaks documents aren't necessary to prove corruption of the collective interests not to drown millions.  Simple innaction is.  The political forces in favour of Oak, Maple or Teak are weak and conflicted, and incapable, in my opinion, of suppressing the long term viability of bamboo.  Taxing carbon gas emitting fuels is a perfect way to guide ecological choices through economic choice.  Taxation-invisible-hands are necessary when the social ecological costs on outsiders to transactions cannot be captured any other way.  Such taxes are helpful even if the proceeds aren't earmarked for atmospheric cleansing or polar cooling.

While economic choice is usually the same as ecological choice, it is important to correct that choice when it is distorted.

Sunday, December 5, 2010

Natural Finance for Income Property ventures

Rental/hotel income property owners typically try to maximize leverage.  They use established real-estate lending facilities led by banks, and larger collectors of properties are able to structure as a REIT (real estate investment trust) which provides investors with a shareholder stake of property price increases as well as regular distributions of property income.  Natural Finance can supplement traditional mortgages, and replace REIT structures.

Investing in Mortgages can be more attractive than bonds because cashflow yield is higher (principal repaid along with interest monthly), and investing in REITs can be more attractive than stocks for its balanced cashflow and share of potential property appreciation.

For an income property investor, finding the first 70-80% of investment through a bank mortgage is hopefully easy.  Funding all of the rest with other people's money is difficult because the smaller investment stake of the owner, the greater the risk to investors that the property value might fall below the purchase price and be abandoned by the owners. When gathering remaining funds from several junior/minority investors (either in equity or loan form), these investors should have concerns over auditing standards and ponzi/madoff schemes.   Such investors both require high returns to invest and are scared off by the suspiciousness of high promised returns.

 Natural finance is both compatible with traditional mortgages as a supplement, and superior to them.  They offer the same general philosophy as stock investment in that payments to investors are based on the availability of surpluses and cashflow.  They are far superior alternative for stock investors, because a natural finance corporation is obligated to ask for more money for future projects instead of hoarding surpluses, and corrupting them for management discretion.  Distributing surpluses fully is a typical promise of real estate income investments, and so formalizing a real estate corporation under natural finance principles provides investors with the assurance of following through on those promises.

There are 3 entrepreneurial monetization ambitions:  operating income, management fees, and capital appreciation.  NF in addition to separating ownership and capital can also facilitate the separation of the 3 interests.  First, mortgages and natural finance queued soft loans are each primary claims on the operating income of the venture.  Mortgages are a hard claim in that they are owed regardless of whether the income is generated.  Queued soft loan bidding process allows each investor to bid according to his confidence in the sustainability of the operating income, but such investment remains a bet primarily on the eventuality and sustainability of that income.  In a recent post on open partnership mechanics I showed how and why entrepreneurs might transform their enterprises into an egalitarian partnership (commune) using set or democratic entry prices for members.  Since entrepreneurial drive generally involves sometimes irrational need for control, a founder's reluctance to allow open membership can be overcome by binding the partnership to a management services contract (for a set term) for his services prior to opening membership acceptances.  The management and operations services company can also be a natural financed commune if the entrepreneur chooses it to be, and thus all 3 monetization ambitions can be marketed independently to investors and partners, depending on which area which investors are most interested/confident/hopeful.

While providing financing more cheaply and within the flexibility of actual cashflows of an enterprise while simultaneously providing better returns for investors are important and sufficient benefits,  independent comptrolling of the enterprise is especially valuable for minority shareholders in private enterprises.  An independent comptroller is better security for investors than independent accounting audit.  Transactions are monitored and approved live, and funds and accounts secured, rather than the auditing process which provides an after-the-fact tracing of events and transactions by a firm that is essentially under a revocable employment-services contract and that is willing to provide all permissible favourable-to-management interpretation of transactions.

The benefits to enterprise of an independent comptroller is that first, it attracts investors and you can pay them less if you provide them with more security.  Second, its less expensive than the regulatory compliance and auditing costs of public companies.  Third, an independent comptroller allows the enterprise to use debt (QSLs) as currency with all of its stakeholders, allowing it to defer compensation and payments, without forcing its recipient-partners to rely on the entrepreneur's faithful loyalty to his contracts, or personally conducting the due diligence necessary to ascertain the value of promised securities.

For monthly income property ventures specifically, the comptrollership function is less time consuming (expensive) than most other businesses, since financing transactions are generally few and large, valuation of projects is very predictable, and little to no mediation and consulting on projects and agreements is necessary.  The comptrollership function in an income property venture is primarily limited to ensuring funds stay where they are supposed to, funds are paid when they are supposed to, and executing operations are being done dutifully (generally easier for income properties), including verifying the existence of buildings and renters.

Saturday, December 4, 2010

Queued Soft Loans vs traditional loans. - Math

Natural Finance uses queued soft loans as principle financing instrument.  Presented here are details of the financial advantages of queued soft loans.  Secured queued soft loans are similar to open interest only mortgages in that interest and depreciation are paid each month.  General (or unscured) QSLs have no fixed payment amounts or dates, but rather controlled payments based on cashflow.

Consider a multi-unit residential property investment that cost $1M to buy, and generates $100K/yr in profits.  If seeking to finance the entire amount, a shrewd banker might calculate that the applicant entrepreneur would say yes to 10% interest only mortgage,  on the basis that he may earn a maintenance/management salary, and would gain if the property value increased.  At a 10% mortgage interest, the venture would pay $1M over 10 years to the banker, and would still owe 1M at the end of 10 years.

As a General QSL at 10% interest, after 10 years, over 337K is repaid even if no new investors buy out existing 10% loans. This online spreadsheet clarifies the loan dynamics on a yearly basis

The main advantage of natural finance queued soft loans is that interest rates charged is brought down by new investors buying out existing ones.  In our example, after 1 or 2 years of operating with 100k in operating profits, many investors would consider lending to the project at 8% attractive.  Even our initial shrewd banker who had the power to insist on the initial 10% would be entirely content to reinvest at 8%, after both operational soundness is established as well as demonstrated competitive investor interest.  Under natural finance, if there is $1M in the world content to invest in your project at 8%, then the natural/average interest cost will fall to 8%. After 5 to 10 years, after substantial equity has been built up, the natural finance rate can drop to 6% or less.

A traditional interest only mortgage at 7.63% interest, where any surpluses after interest costs are used to pay down principal on the mortgage achieves the same 10 year paydown rate as a 10% QSL.  As shown on sheet 2.  This means that 10% natural finance loans are equivalent to 7.63% traditional mortgage both for the enterprise, and  for total investor repayments over 10 years. Note that if an investor is repaid within 5 years, he will have earned substantially more interest under the natural finance option than under the mortgage option.  The first $323K of investment is repaid in 5 years organically, but substantially more can be repaid if new investors come in.

A further advantage of natural finance loans is the tax advantages to the enterprise.  By repaying principal earlier (retiring the head-of-queue loans that are repaid), natural finance allows higher interest to accrue (tax deduction) even when it is not paid immediately.

Secured QSLs are almost equivalent to interest only open mortgages when there is no depreciation on the secured asset (such as real estate mortgages).  The differences are in fact advantages.  First, the obligation instead of the right to pay the mortgage down under specific surplus conditions means additional security to the lender (who always retains the option of reinvesting any repaid amounts).  Second, and most importantly, the fact that natural financed corporations are independently comptrolled means that expensive government loan registration services are not necessary, and that all enterprise contractual obligations and loan covenants, such as insurance requirements, are monitored and enforced.  Thus a theoretical risk free loan, is made practically risk free and cost free.

The cash flow of secured QSLs is identical to the interest only mortgage model shown on sheet 2.

The primary consideration in setting interest rates on real estate is the loan-to-value ratio.  It is generally considered completely safe to lend $500K on an insured property worth $1M to anyone, because it is generally certain that the proceeds from foreclosure would exceed the costs.  Because of this, when loan to value is 50% or less, the very lowest financing interest are available almost regardless of the credit quality of the applicant.  We will use 5% as this risk-free interest rate.

A hybrid of secured and unsecured QSL natural financing is shown on sheet 3.  A 50% loan to value secured QSL of 500k @5% is used, and the remaining 500k loan is through general unsecured QSLs. @10%.  Natural finance insists (exceptions are outside this context) that surpluses are used to pay all general QSLs ahead of secured QSLs.  This hybrid model generates 503K of equity over the first 10 years, and all of those investors who chose unsecured QSLs are repaid in full.

Unsecured QSL investors can never be diluted by future security issuances.  All future QSLs will have lower payment priority than their QSL.  Natural Finance encourages Capped QSLs which provide further certainty to investors.  For example, the first $200k principal in queue position is guaranteed to be repaid with full interest or with $400k (double the principal value) if lifetime cumulative operating surpluses of the venture either exceed the amount owing or $400k.  Secured QSLs have payment priority for monthly interest payments and to be paid off if secured collateral is sold.  Because unsecured QSLs use simple interest instead of compound interest, and as shown by the linked spreadsheet, that a 10% QSL rate is equivalent to the enterprise in the long term (10 years) to a 7.6% compound rate,  investors that are bought out or paid off early (first few years), make a much higher return on what turns out to be a short term loan.

Natural finance provides higher returns to investors and less risk, and provides lower financing costs to enterprise.  It is therefore naturally superior to traditional finance options.

Sunday, November 14, 2010

McDonalds super bonds vs Pizza Pizza

This summer McDonalds issued bonds at record low yields which as far as I know continue to trade below US debt of the same maturities.  The reason some investors would buy at such low yields is that McDonalds is a very healthy company with worldwide diversified revenue sources.  While bond rates are based on a company's stability, it also has solid international growth prospects.  One can easily imagine that McDonalds will continue to be a stable dominant fast food provider for the next 30 years in North America because it is a cost and value leader in a market segment unlikely to dissapear.  If we were to guess at the future prospects 30 years from now between McDonalds and the US Government, its easy to pick McDonalds as being more likely to have a sustainable outlook.

The reason that investing in any bonds (continuing focus on MCD) below 5% yield is a poor investment, in my opinion, is twofold.  First, there is operational risk.  Competitors could bribe politicians or the judiciary to declare McDonald's value menu "dumping" or other anti-competitive argument preventing growth for those other than McDonalds, and thereby destroy some of its capital value.  Operational risk 30-50 years out, can also be fantasized as technological advance that enables a desktop device to synthesize french fries with little effort, and less expensively than MCD can provide for customers.

Second, and most important, is the risk of further dilution of debt.  McDonalds already has $15B in debt, and only $13B in equity.  The latest debt issue is already portrayed as borrowing because it can, rather than because it needs the money.  If it can borrow cheaper than governments, why not issue more debt next year, say another $5B, and invest the proceeds in higher yielding government debt?  The answer is that it will as long as investor sentiment favours it over the U.S Government.  Greek 10yr bond yields were below 3% in october 2009 (have hit 12% since).  There is no impossibility of the same happening to US Bonds, and if they do, then McDonald's appetite for more debt will rise significantly.  Investors of McDonalds existing 3.5% debt will see their worth plumet alongside MCD's new issues to match US debt yields, if so.  Therefore, there is no real actual relative safety to US treasuries, because whatever temporary safety exists will be cannibalized away by MCD itself through further bond dilutions.

In 2-10 years, its same store sales should level off in Europe and Asia.  Lets say they add $25B in equity organically over 5 years, but then earnings level off at $6B per year after that.If that were the case, they would remain at almost the same market value if their earnings multiple was 14 times, which I would consider too expensive, but  many other investors would happily bid for one of the DOW stocks most likely to survive 50 years.

I present this scenario to portray a mature company with great cashflow ($6B), and very cheap debt.  It becomes a ripe target for a leveraged buyout, which totally destroys the value of holding debt, as there is extreme dilution of debt holders from such action.  The largest (attempted) LBO takeover in history was for BCE and expected to close in the middle of winter 2008 financial crisis.  It was averted only due to general solvency climate concerns of the financial crisis itself, and would have closed disastrously for bondholders days before Lehman Brothers collapsed.

The more attractive a corporate bond is, the more likely it is to result in future dilution.  A primary rationale for natural finance instruments is the impossibility of dilution, and MCD would be able to finance significantly cheaper than their already great rates, while investors would genuinely get the security they may imagine they have through natural finance queued soft loans.  AAA rated bonds cannot exist if sovereign debt is not AAA, and no financial entity can insure others debts and maintain investment grade rating.

A credible alternative for ultra safe seeking MCD debt investors may be equity in a small canadian company currently yielding over 12%, and trading at under 80% of book value. Pizza Pizza
is also is in the fast food business (delivery too), and a well respected brand in Ontario with sustainable future.  It controls nearly 600 restaurants.  The specific attractiveness of this equity is that it has no debt, and $10/share in long term interest bearing investments, and a P/E of 8.  Potential reasons that it has underperformed are that it is in the fast food business and is not McDonalds, and has not had much sales growth since the recession, that it expanded in 2009 by issuing an offendable number of shares (financial crisis influenced), but most likely the strongest reason for its underperformance is that investors misunderstand its performance as a fast food chain with muddling sales growth, instead of a bondholding trust with stable restaurant sales royalty streams and few material expenses.  Its payout rate will drop slightly when it converts to a corporation in early 2011.  A partial cause for its underperformance may be institutional restrictions on owning its current income trust form.

Pizza Pizza management certainly has the power to destroy shareholder value like any other public corporation.  Current management at least has the good graces to do nothing.  The main risk is that its long term investments are in a related private company that symbiotically owns a significant amount of the trust, and the relationship lacks crystal clarity (It is audited however). The business success of the private company appears to be on a roughly identical restaurant success basis, though both are insulated from day to day franchise operations.  The risk is that incestuous corruption between the two entities could be masked by euphemistic reporting language. Both McDonalds and Pizza Pizza have sustainable long term operations, IMO.  PZA's 8 year projected payback with above natural returns is more certain and more attractive than MCD's 30 year payback at below natural returns.  Even if both have equivalent sustainability expectations after payback period.

Pizza Pizza could also significantly benefit from natural finance soft loans instead of its share structure.  The risk profile for loans backed by the next 8-12 years of operational surpluses are comparable to government bonds.  Significantly better than the current market demanded rates for its units could be achieved.

I have no negative-benefitting holdings in MCD, and do have a long position in PZA.UN.

Saturday, November 6, 2010

communal equity accounting - large open partnerships

Egalitarian enterprise ownership provides a function similar to Natural Finance Comptrollership in that it controls hierarchical management power concentration.  A circle of equal partners has to be managed for the equal benefit of all the partners, and equality membership is the only effective way to enforce it.

In my last post, I discussed various ways to structure an equal partnership.    The most interesting of these options was one (3rd option) offering an equal partnership with equal low financial commitments amongst partners. This is a more formal analysis of that option where I will try to keep the more complex parts near the end.

The exciting aspect of allowing low buy-in egalitarian open membership/equity in a project is making projects accessible to both rich and poor members.  It can replace financing and ownership structure for most projects, but is specifically tailored for real estate projects/municipalities, multi-level marketing organizations, and volunteer charities or semi-volunteer organizations. 

Natural Finance provides a more flexible and cheaper financing alternative than the loan syndicate described in the original scenario.  Natural Finance uses queued priority open soft loans for financing where each investor is guaranteed to never be diluted by future obligations.  Queues exist (in order of payment priority) for unsecured loans, secured loans, deferred compensation, and purposeholder/"shareholder" dividend-equivalents.  An impartial comptroller is assigned to the organization to ensure funds flow through accounts as agreed, and to enforce all other agreements entered by the organization, and so facilitates partnerships in the organization by ensuring trust in it by its partners.

Another function Natural Finance Comptrollership provides is more flexible accounting options than standard GAAP.  GAAP procedures aim to portray an organization to outsiders as an estimate of its liquidation value.  While useful, a partnership with an open buy in price must use the principle of setting a buy in price which doesn't disadvantage anyone based on time of buy in.  So internal information must also be accounted.

Minimal investment partnerships within a natural financed organization may as well be labeled Natural Partnerships.  A natural partnership share has many similarities to standard corporate shares.  It is a share of paid up equity, a right to vote. a right to share in future profits, and is freely transferable.  Unlike a standard corporate share, it also has an obligation to pay its share of unfinanced obligations.  Because of this last feature, the shareholder has the right to abandon his share most likely to avoid paying such obligations.  There are thus 2 financial components to a natural partnership share.  A membership fee and a paid up capital amount.  The membership fee is the small buy in fee that can start an egalitarian organization.  The membership fee is forfeited if the share is abandoned.  Paid up capital is not forfeited however when abandoned, though share of future gains is forfeited.  Natural finance queues enable a distinction between returning past dues, and shares of future streams.

For almost all natural financed organizations, paid up capital of natural partners would be accumulated exclusively through paying back of lender principal.  Basically through accumulated profits.  In natural financed organizations any capital contributions made by partners are lent under the same terms available to general investors.  If, in the future of an organization, contributions from its partners must be raised as a last resort, then its likely the partners agree to make those contributions in the form of interest bearing loans rather than as capital contributions.

Deferring discussion on calculation of open partnership share value (called communal equity) for a moment, a new partner joining the organization, if he is the n-th partner,  owes 1/n-th of the partnership value to the other partners on top of the membership fee.  If the prospective partner is interested in joining mostly for employment income opportunities he can derive from the organization, then it is likely the organization is willing to negotiate with him to pay that amount with no interest, at a speed commensurate with his responsibilities.  If the prospective partner only has a financial interest in the partnership, then he is likely expected to pay the partnership's full entry price without any organizational concessions.  The motivation for a financial partner to invest in the partnership rather than through natural finance loans to the organization is usually in addition to natural finance loans.  Individuals may only purchase a single partnership share.  It grants them a vote and access to collaboration opportunities, and so can be supplementary to other financial stakeholdership in the organization.

Communal Accounting is a supplementary measure to GAAP accounting.  It does not prevent standard GAAP income statements and balance sheets.  An additional accumulated communal equity account is tracked which "capitalizes" most expenses of the organization that are permanent reflections of past member contributions to the firm.  The principle of communal equity is to record those expenses incurred by the first members in the buildup of the organization, so as to equalize contributions made by the first and last members.  Members joining now or 10 years from now should be indifferent to the joining dues.  Expenses that are not a personal benefit to communal members nor are part of the costs of goods produced for sale are presumed to build up communal equity (value).  For organizations that don't provide direct benefits to their members (such as housing, food etc...) then supplementary communal equity will be accumulated losses (with minor timing adjustments).

As analysis, consider an open communal owership of an art piece (soup can drawing) that is bought with a 100% vendor loan.  The only costs in maintaining it are insurance and interest on the loan.  Initial communal membership of one.    The vendor gets no cash, but will collect rent equivalent interest and avoided insurance costs, and holds the art as collateral.  The buyer hopes that the art will appreciate in value more than the interest and insurance costs.  The commune sets its risk to (almost) zero in allowing new members to join at the value of accumulated interest and insurance costs.  A partnership set at the time of purchase would always be set at this value.  Partners joining in the future, however, have the advantage of waiting to see if the art appreciates in value more than the buy-in costs.  Therefore, a markup percentage is appropriate on the buy in set price.  It can be set monthly or quarterly, and can be negative if market conditions demand so.  5% or 10% markup is considered naturally acceptable capital returns, and 5% will attract more partners than 10%.  Expressing it as a percentage markup is important for disclosure purposes, communal voting on setting the markup, and mathematical simplicity in rewarding each existing communal partner.  The value of soup can drawings, as any project venture, is highly subjective, and categorically impossible to predict.  A 5% markup will attract more members than a 10% markup.  At 5% annual interest and insurance costs, the open communal buy in price would increase by 1/n-th of 5.5% (with 10% markup) of the original asset value.

The above venture excludes valuing either the advantage of having possession and enjoyment of soup can drawings, and the revenue potential of charging a few cents to soup can drawing aficionado visitors.  Any revenues earned by visitation fees reduce the cost of partnership buy in provided they don't exceed the expenses.  Retained profit also increases buy-in price by increasing equity.  Ironically, both losses and undistributed profits increase share value by the same amount, while breaking even does not (to be contradicted later). An aside, but interesting alternative to the vendor selling to the buyer, is the for the vendor to form a communal partnership with the buyer.  The vendor gets to insure that insurance is up to date on the asset, and may continue to enjoy the possession privilege, and the buyer gets half the speculative ownership but half the risk (obligations to pay interest and insurance).  The buyer's ability to abandon the project returning the collateral is unaffected.  If the communal partnership grows to 1000 members, then the vendor will have succeeded in divesting 999/1000 of his interests while continuing to participate in the potential increase in market value, its insurance security, and potentially its viewing pleasure.

The paradox of an organization losing 100k per year being valued the same as one earning 100k is indeed nonsensical.  Net Present Value principles apply.  For presumably perpetual projects with aggressive market value based depreciation schedules for assets (as natural finance secured QCSLs demand), then an earnings multiple of 5-10 times over and above tangible equity is a fairer open buy-in price than accumulated communal equity.  Open buy-in price is the greater of the 2 values.  Tangible equity is essentially the liquidation value of an organization, and excludes intangible assets such as goodwill and brand image.  If intangible assets are a substantial value of the organization, then the multiple of earnings can be justified higher.  The importance is a formulaic buy-in price based on earnings and tangible equity.  Terminal value projects such as an oil well, gold mine, or drug patents have different valuation formulas.  They are also NPV based, but not discussed further at this time.

When the right to abandonment is invoked by a partner, the membership fee portion of his partnership share is forfeited to the organization.  Their share of communal equity is segregated into passive communal equity.  Passive communal equity is only returned to investors as distributions are made.  No profit is available on their shares.  If the organization requires future partner contributions, they are drawn proportionally from passive communal equity and active partners/communal equity.  Any distributions made to partners whether profit shares or results of the sale of the organization, are made to passive communal equity holders as well, but reduce the passive shareholder balance.  New partners buying into the communal partnership have their contributions distributed with passive communal equity counting as half of its proportion.  The rationale for reduced participation of passive equity members is that recruiting new members is an active action by the existing active partnership.

One major advantage of a communal partnership over standard corporate shareholding is that management abuse of shareholders by diluting equity is prevented.  The price of admission to the partnership through either markup of communal equity or earnings multiple above tangible equity can be set through a democratic average of partner desired amounts.  The structure makes it impossible to bribe one manager for preferential stock distribution, because each person is limited to one share, and a price is set for all buyers.  yes/no decisions by potential buyers of a fixed or formulaic price are still market based pricing of stock issues.

For most projects, the membership fee is expected to be $1000.  Membership fees become organization equity.  Each share would have a book value of at least $1000 because of this.  Consider an organization like General Motors with 1-10 million people affected by its operations including customers.  If such an organization formed as a communal partnership with 1m members, there is $1B in equity from membership fees alone.

A communal egalitarian partnership can have senior and junior partner divisions.  Junior partners are those who haven't fully paid up their partnership share yet, but are current with their negotiated payment schedule.  A partnership share can be split among a group, though no one can own more than a share.  Those partners with more financial resources than other partners can contribute additional funds through (natural finance) loans.

A communal egalitarian partnership can replace many natural finance comptrollership duties other than account control if the partnership is large enough (5+), as peer review/monitoring enforcing partner commitments to the partnership is likely serves investors as well.  A communal egalitarian partnership is more trustworthy to outsiders also because it allows outsiders to join it.

Thursday, September 23, 2010

financing egalitarian communes where members have disparate financial means

How to you arrange temporary ownership of a commune, such as a co-housing arrangement, where each member is unable to provide equal down payments, but an eventual equal ownership status is desired?

This is as far as I know, not only an open important finance problem, but one that has been untouched.  Applications include all cooperative ventures and mutual insurance equivalents.

Marriage is a full commune.  It is a commitment to equal share from personal entitlement (70% of marriages in North America result in divorce).  A cohabitation arrangement for the purchase of co-housing involving multiple parties does not imply the same trust levels among the parties.  The main issue is that those who put nothing down are motivated to walk away from the property if the market value declines, while obtaining "free" capital appreciation if the market value goes up.  Thus they have no risk and extreme possible reward.

We will look at 4 general approaches to establishing a fair agreement between parties.  Each can have some advantages, and the choice is affected by laws of a jurisdiction (eviction laws, ability to walk away from property and mortgage).
First, If all parties agree to an equal share and cosign one large mortgage, the question becomes what is the value of cosigning to and for the members?
Second, Those parties putting up 100% for their shares can cosign a mortgage, and then reissue loans to those putting a small fraction of down payments at a profitable interest rate margin to reflect the relative (lack of) risk of each member.
Third, all investors put down equal minimum payment and then finance their share independently, or more likely collectively.  The question then becomes how to do this as efficiently as possible within the financial system, and since the answer is to finance collectively, how to minimize financing costs and the substantial risk borne by the lender.
Fourth, those investors who put up more upfront money could obtain a 1/x (1/20, in example of x=20 partners, buying a p=$100k house) share by putting down less than p/x ($5k) for their share.  Those putting less down would end up paying more than $5k for their shares + interest on the loans.  The justification is the relative risk of each owner to a drop in market value.  The question becomes how to calculate a fair discount.

All of these scenarios assume the concept of net partial ownership.  Even if there is mutual cosigning, each party is responsible for his actual share of the debt, so if 2 people buy a house, where 1 puts up all cash for his share, and the other puts down nothing, then even if they are equal owners, proceeds from selling the house are typically split in half, and then those who were responsible for debt for their share use those proceeds to pay down that debt.  In such a 2 person cosigning situation, if the 2 people buy a property for $100k that they immediately resell for a $10k loss (typical total transaction costs if resold the same day for closing price), then the first investor gets $45k back, but must pay the bank an extra $5k to cover his cosigning obligation, and thus the cash partner lost the entire $10k, while the debt partner lost nothing.  Note that an imposed fairness, as a baseline, is that all partners should be equally responsible for losses.  If the project loses $10k, then the partner who had no down payment should owe the partner who put up cash (at least) $5k.

Another concept the reader should be familiar with is the call option.  A homeowner with no down payment and no liability if he walks away effectively owns a call option on that house.  If it goes up in value, he's worth more, and if it falls he doesn't lose anything.  Call options on stocks and futures that expire 1 year from now at a price equal to the current market price are worth 2%-8% of the market price depending on the individual stock and how volatile its pricing is, and how uncertain its future.  It drops to 1%-3% when the market price is 10% above the call option strike price.

The first scenario (cosigning risk transfer privilege) is the most common approach partially because it is suited to marriages, and simplest, and partially because it satisfies banks.  A starting point in valuing the benefit of cosigning a loan is to grant the cash buyers a loan by the debt buyers in the event of a loss.  In the 2 person example, the debt buyer would owe the cash buyer $10K as an unsecured loan after liquidating the property.  If the debt buyer had invested 5K instead of 0, then no loan to either party would take place upon liquidation because both parties lost $5K.  Setting an appropriate interest for the conditional loan is a market agreement between high downpayment investors and low downpayment investors.  This can be fair to the cash investors if such a loan is likely to be repaid, and so basically only offers protection in the event the project is unattractive to the borrower since failing to pay due to hardship makes the conditional backup loan of dubious value.  Although, this arrangement transfers all of the risk (if loan is repayable) to the low downpayment investors, the arrangement can be attractive to them if cosigners reduce the interest rate of the loan sufficiently.  The appeal of this solution is relative simplicity.  An alternative is partial indemnity instead of full indemnity to the cash buyers.

The 2nd approach (relending cooperative) is similar to rent-to-own schemes.  It probably involves some right to evict and take control of a delinquent voting-rights-holder, but a delinquency option can be an "own-to-rent" right of abandonment by the borrower.  This approach can be used with many partners, and in any situation where partners must buy a share of a project (even without large secured loan).  With a large group, and bank involvement, the bank has a lending relationship with the partnership with individual investors co-signing.  The  partnership is owned in proportion to paid up capital, with senior partners (majority veto of further investment projects) having fully paid up capital.  The borrowers take out "semi-unsecured" loans from other stakeholders in the partnership (bank, partnership entity, and partnership investors), with terms that when fully paid they are granted senior partnership status, and proceeds from the sale of the partnership close out the loan.  The loans are open, such that borrowers may fully pay off the loan in order to participate in proceeds from sale of partnership, or gain voting status to stop such sale.  While interest rate charged to borrowers are set individually, a preferred model is to offer a premium over bank funding that varies according to paid up capital (and adjusts downward over time as more paid up capital is accumulated through repayments).  For normal borrowers, premium over partnership funding rate would reach 1% or less when a borrower reaches 50% paid up capital.  This approach creates a lending market for borrowers to choose from.  The open loan criteria means that borrowers can renegotiate at any time, and lenders are able to transfer the loan as well.  Transaction costs are minimized by a single standardized legal agreement where only interest rate and repayment rate are varied.

The third approach (equal minimal risk) guarantees that the ownership situation is fair and equal to all investors at all times.  The cost is likely much higher financing costs for those that would be capable to pay cash for their share.  Project organizers and investors agree to a minimum down payment and payment schedule from investors.  Those potential investors who are unable to meet the payment terms, can pool together and split 1 share.  In its simplest version, 1 lender (bank-like) lends the necessary proceeds above accumulated down payments to the partnership at a unified interest rate and terms.  In order to minimize the interest rate, the bank is offered terms of full forfeiture of individual shares and partnership assets after 6 months delinquency.  After 3 month's delinquency of one member/partner, the other members are offered the opportunity to take over the delinquent member's share obligations, and all of those that agree get an equal fractional share of that share.  No compensation is owed to the delinquent shareholder.  After 4 month's delinquency, the partnership can offer the membership share to outsiders with any proceeds for purchase of the share obligations going to the partnership.  Prior to "bank" repossession of the share, the partnership may vote to socialize ownership of the share by a majority to eliminate the share and distribute its obligations among all other shareholders.  The advantage of this structure is that all investors can walk away and abandon their share of the project, or resell their rights/obligations.  Investors with substantial capital can syndicate with the primary "bank" lender to form a lending partnership that acts as one, and where individual investors break even on the high interest rate charged to the partnership.  This is suited to high risk projects.  An interest rate premium that decreases over time, as the project matures and more paid up capital is accumulated, can make sense.  An example of 12% for first year with a 1% reduction each year for the first 5 years might be typical (improvements below), depending on loan syndication participation and overall project quality.  The ability to over-ride eviction laws in a jurisdiction can be important in permitting this type of risk taking by the lending syndicate.

The fourth solution (share discounts) is appropriate when partners with low capital are confident of the project's success.  This option involves cosigning loans by all partners.  Allowing full paying shareholder to underpay for their share, is direct compensation for their cosigning benefit and project participation.  It differs from the cosigning-risk-transfer-privilege (first solution) in that it involves a less speculative risk transfer to the capital-rich partners (if the borrowing partner must abandon due to health reasons or inability to pay, then an unsecured loan from them is worth little).  As a base-line for pricing, transaction costs of reselling the project at the same nominal price on same day of closing should be fully reflected.  So if those transaction costs are estimated at 10% of the project value, then all those who pay less than 10% down for their share "price" be increased by up to 10% while those who fully pay for their share should have their share cost reduced by 10%.  Note that we should not adjust for market risk (project value increasing or decreasing) because that is theoretically fully reflected in the purchase price.  While market price of assets reflect the cost of insurance and maintenance, the inequality of loss between those that fully pay their share versus those who fully borrow for their share, means that either the highest cash investors have full unilateral/veto control over insurance coverage and maintenance programs, or they must be compensated for democratic control of these issues by all sharemembers.   The first option is easier.  Spelling out insurance carriers and coverage together with maintenance policies (less important than insurance for most assets) is an alternative to succumbing to total insurance decision tyranny.  The one other factor that should be adjusted among sharemembers is the value of the call option held by low to no cash down members.  Its value(s) should be split evenly betweens sharemembers.  Estimating the 1 year call option premium for each sharemember can be done using the Black-Sholes formula where the strike price of each option is the project cost less the member's down payment.  Those members who hold a higher than average call option premium (low cash investors) as part of their share would pay the difference from the average to those who hold a lower than average call option premium (high cash investors).

The dynamics of the third solution are the most interesting.  If the project is abandoned by nearly all, then any person willing to take over project obligations can satisfy the lending syndicate, and the syndicate members have sunk costs motivating them to do so.  Project members with good credit ratings and borrowing power, can join the lending syndicate by borrowing at lower costs than they are lending, and securing the loan partially with their syndicate share.  This effectively makes the 3rd option an improved 2nd option, because it simplifies the loan into a single agreement.  In a large member project, the risks tend to be limited to market risks, because the network effects of a large group means relative certainty that one member's hardship causing loss of his share is assumed by another member or member's contacts if the project remains viably marketable.  While the project commits to a fixed payment schedule with no prepayment option, it can purchase a syndicate position from any syndicate member through market agreement (if it purchased the entire syndicate, it would have the same effect as repaying the loan in full since it would be paying itself).

In my next article, I will show how natural finance secured queued soft loans can help both fairly set interest rates in a manner continuously adjusting to market conditions, and meet flexible operational needs of a project.  Natural finance can basically help a large group of poor communalist nitwits fund an expensive project.

Monday, September 13, 2010

GDP and social policy - Improper politicization of statistics

The most common mistake in social sciences is measuring what is easy to measure, and then inferring that the result is relevant to performance.

When we smash an anthill, we guarantee full employment and frantic activity for the ants.  Similarly, destructive hurricanes in Florida significantly increases GDP and employment in Florida.  The activity of replacing destroyed homes and infrastructure is indistinguishable to economic GDP than the activity building new homes and infrastructure.  Yet the latter increases the nation's wealth, while the former merely restores it.

Distinguishing spending between durable, maintenance, and waste spending can hope to measure productive economic spending even if it focuses on the conceivably measurable economic value rather than all imaginable human wealth increases.  Measuring transactions measures to a large extent wealth transfer rather than value creation.  Making a new car creates value if someone needs the new car.  Buying a new car confirms that value creation and transfers wealth, and also increases capital for the car maker to make more cars.  Its an exchange of value rather than a transfer of value. Transacting on a used car is also an exchange  of value, but neither creates nor confirms value creation in the process.  The depreciation in price (from new) is not a waste but rather a natural maintenance expense given current technology levels.  The eventual need to replace doesn't negate a car's useful service life' value. Education also involves value creation whether paid or not.  Any payment for the conversation or diploma grant can be viewed as a separate side-transfer of wealth.  Legal and financial engineering where it permits the creation and consumption of value through contracts, charters and financing creates value by facilitating the creation of value.  Food, shelter, and healthcare are at their core human maintenance expenses.  The first two can all be viewed as value creating in that people would voluntarily purchase higher value options even if gruel and hovels were free, whereas healthcare can have a substantial extortion component in corrupted markets.

Gifts (negating satisfaction of benefactor) merely transfers value.  Theft destroys value.  The benefactor suffers stress and violation, and both the benefactor and beneficiary waste resources and anxiety over security (thief must avoid getting caught).  Security in general must be viewed as a waste.  Hiring a militia to guard your car does nothing to preserve or enhance the car's value, merely its possession.  The security forces further lose the opportunity to engage in value creation activities.  Both risk and corrupt market insurance are waste as well.  Transfering risk to a third party is a mere transfer of risk.  A social guarantee that a car accident has minimal financial impact on its actors has value, but the profit and bureaucracy involved in providing that guarantee is waste.  Barriers to financial, technology and social arrangements that would reduce that waste are waste.  Lies are similar to theft in destroying value.  They require a (legal) security force/effort to guard against.  When investors choose risky stock investment with inherent uncertainty, and vulnerability to management lies and betrayal, and perpetual refusal to issue sufficient dividends, they tend to gamble under delusion of greed.  The appetite for risk is a misguided lack of recognition for the distaste of capital losses.

Enhancing trust creates value (roughly out of thin air).  It lowers militia and legal security requirements, as well as diminishing concerns regarding lies and betrayal.  The Natural Finance Comptroller function is one technology that enhances trust.  Having a 3rd party control all enterprise agreements removes the uncertainty of avoiding obligations, and so makes suppliers, partners and investors more likely to trust deferred compensations, and more agreeable to partnerships with less upfront cash distributions.  Reduction in legal costs, and extra opportunities made possible by enhanced trust from 3rd party control are likely to favourably outweigh the costs of 3rd party control.

Back to GDP calculations, when you eliminate waste you decrease the GDP calculated economic indicator.  Distributing wealth widely accross society is a legitimate goal, and waste spending is one means to do so.  A more useful means are to use government taxation to fund grants and loans to projects that will create value.  In order to help re-employ those displaced by waste reduction.  A similar misinterpretation of economic indicators occurs when imports are viewed negatively.  If importing tube socks for $2, where the alternative is to produce them yourself for $5, then importing them gives you tube socks and $3 extra.  Economic value is the goods and services that satisfy needs and wants, not the little green pieces of paper that make people provide these.

EDIT: the purpose of this post is to outline political corruption of the GDP statistic.  That recessions are simply defined as 2 quarters of GDP decline, makes simple GDP manipulations through increased deficits a political tool to avoid the label recession.  Waste spending can be labeled economic strength or growth.  That national income transactions remain relatively stable can overlook the wealth destruction that has occurred in the same period (A durable wealth statistic is provided in comments), and so policy can misunderstand the health of the economy in its actions, or ignore simple innexpensive processes that can substantially increase wealth and value.

Monday, September 6, 2010

How capitalism harms innovation/capitalism

The relationship between financiers and entrepreneurs harms capital allocation, innovation, and entrepreneurial success is the longer title.  I dislike using the word capitalism because it is ephemeral, and without common meeting, and has practical corruptions that differ from its theoretical purities.  Capitalism harms or is anti capitalism becomes a sensible sentence.

Common shares determine ownership in a corporation.  Both in terms of voting power, and share of distributions (dividends or proceeds from sale of corporation). They have the same failing as general democratic institutions in that a majority shareholder or majority forming cartel obtains decision authority over the corporation.  The basis that all shareholders must be paid equally if they are paid is insufficient to ensure that majority decisions benefit all shareholders.  Entrepreneurs, managers and Financiers have different general objectives.  The financier wants to be paid back.  Entrepreneurs would tend to have grander vision and aspirations of empire than managers, but both seek employment benefits.

Corporate governance is on its face, a board of directors appointed by shareholders to monitor management's duty to maximize shareholder value.  In practice, for public corporations, management is very influential, often naming all board members with the president as chairman.   This occurs because most investors find it easier to sell their shares than to seek control of the board or fire management.  There is no widespread motivation to expose stock ownership as a scam since financiers need other gullible financiers in order to divest.  Hope and greed that delusions of stock value persist, prolongs the cycle of further financier participation in the scam.  We invent the matrix, and reinforce it.

The major conflicts that occur between management sympathetic directors and non controlling shareholders are reinvesting surpluses (into for example buying other companies) instead of paying dividends, and diluting investors by issuing more shares (many to employees).  Proof that buy and hold shareholder strategy fails is that  The average large corporation lasts 40 years before bankruptcy, and dividend payouts rarely compare to bond payments (which include repayment of principal at end of term).  The only genuine hope for corporate investor returns is through a takeover.  Both bankruptcies and takeovers are quite cyclical, but bankruptcies outnumber takeovers in both value and instances.  If buy and hold is foolish for 100 years, then it is necessarily foolish for 5 or 20 years.  Insiders, professionals, and stock promoters can sometimes make money by selling prior to collapse, but it is at the expense of foolish passive investors, and either through corruption or luck.  Proof that management of public companies control shareholders rather than perform their facial duty is they do not pay very high dividends with the confidence that shareholders will reinvest into the company.

For private corporations, companies who have yet to grow enough to become public or entrepreneurial startups, shareholder financiers need majority control, because they don't have the option of secession present in public ownership (they cannot easily sell shares) if they are dissatisfied.  Because of the ease of selling/secession and no duty to monitor management, most financiers prefer investing in public corporations despite it being a scam.  Entrepreneurs have difficulty finding financing for projects, because there are few willing financiers who fear the pitfalls of public company investing, and they need to insist on a high majority (controlling) share, which is unappealing to entrepreneurs.

Entrepreneurial funding is time consuming.  There is imperfect competition in that the first investor that shows interest is likely to be able to dictate terms.  Just as poor people are more likely to fail due to the high interest of sub-prime loans, ventures with too little return for effort are more likely to be abandoned by entrepreneurs.

Traditional debt financing has problems as well for both investors and entrepreneurs.  For investors and entrepreneurs, other and future debt, or shareholder dividends, makes the security of the debt completely unknown, and so pricing of the debt either must approach worse case scenarios, or be unfair to the lenders in the event of present or future management substantially increasing leverage.  Debt financing further tends to be limited to company asset value.

Real innovation depends on startups and private companies.  Public companies that survive often do so by blocking innovation through barriers to entry, or often through the only known free market: the market for politicians.  The artificial attractiveness of public corporate funding hurts the financing available for startups and private corporations, and thus hurts innovation and entrepreneurship:  capitalism harming innovation/capitalism.

This post has mostly been addressing the principal-agent problem.  Agents (management) have their own agenda despite a pretense of duty to Principals (shareholders).   It's a pervasive social problem, and present in all agency relationships.

Natural finance solves the principal agent problem by making management/labour the only encouraged shareholders, and therefore a principal only relationship.  Financiers are paid first, and as quickly as possible.   Individual financier investments have a known value proposition (far easier to evaluate than common share proposition) at the time of investment, and can never be diluted.  By providing entrepreneurial control and freedom, the necessary motivational drive for successful innovation is present.

Introduction to natural finance

Wednesday, August 25, 2010

Public healthcare is good, but...

technological advances in healthcare seem realistically to only improve medical effectiveness while not reducing its costs.  A sad but inescapable truth about healthcare spending and longevity is that it guarantees further healthcare spending.  If medical treatment prolongs life, then additional different end of life treatment will be necessary in the future.   Deathcare expenses are innescapable. this link states the issue in a polite manner.  Public healthcare faces a difficult obstacle in not wanting to refuse care, not wanting to raise taxes (pay for it), and declining birth rates impose a substantial burden on those most likely to pay the taxes necessary to pay for deathcare.

There is a possible fair and socially distributed solution though:

First, we can predict the costs of deathcare per individual.  Not that I have an educated estimate, but say it is on average $20K per person regardless of cause of death.  If each person paid that much into a government invested savings account such that it grew to $20K by the time they hit age 85, then each person would cover their own deathcare.  Having high income people pay $25-30K, and low income people a smaller $15-10K is perhaps democratically preferable, but an insignificant detail.  $100/year (tax payment) from age 20 to 85 grows to over $30K at just 4% rate of return.  In socialized healthcare, the actual costs of deathcare would still be paid socially.  Individuals simply fund the expected costs.

If funding deathcare becomes politically palatable, then individuals could also choose to optionally insure for specific expensive and experimental treatments.  For example, you could choose to fund possible needed future cancer treatment, or choose to avoid cancer causing behaviours and not insure.   The cost of cancer treatment times the likelyhood of contracting cancer might be $8000 per person.  An alternative, that is unfortunately susceptible to horrifically evil medical corruption, would be to pay tax supplements for each month you survive cancer treatment in order to reflect the death avoiding healthcare you received and be proportional to the quality of benefits you received.

Without these direct, but still socially distributed, funding opportunities, managing healthcare costs will mean reduced healthcare (death panels) or higher general taxation.  The funding proposals would encourage life extending medical research.  Its a clear human benefit to enjoy life extending technology.  We just need to pay for it if we want it.  The high public debt in Ontario justifies these extra funding streams.

Monday, August 23, 2010

Intel purchase of McAfee - counterproductive control

Intel recently made a deal to purchase McAfee for $48/share.  A premium over $18 over McAfee's closing price, and resulted in a 70 cent, near 4%, loss for intel's share price on the day of announcement.  McAfee even at $29/share was very expensive when considering it was 24 times its earnings, with no obvious earnings growth prospects.  At $48, McAfee is valued at 45 times earnings.  Even Apple trades at 20 times earnings.

An obvious, but purely speculative, motive for Intel to make this purchase is that it is about to introduce a product that can benefit from McAfee's consumer security brand (and expertise).  We can value McAfee as two distinct entities.  Its future earning stream, and its security brand.  The future earning stream should not be worth more than 10x current earnings ($1.65B) which leaves its security brand's estimated value to intel at $6.05B. If instead of purchasing McAfee, it paid them  $363M forever each year  (license fees/ joint venture investment), then using a 6% pre-tax cost (estimated 4% after tax) alternative return on capital, the value to intel would be identical to purchasing McAfee's security brand.  It's hard to imagine McAfee refusing $363M/year for what is mostly just sitting and looking pretty for Intel, or that McAfee has key IP its competitors are unable to offer (and if so, the need to pay part of the $363M would disappear after legal protection for IP expires) .

Control of the security brand destroys its value.  A 3rd party security authority protects its brand through necessary integrity and dedication, and as we see from Intel's high offer, can reach exceptionally high intangible value.  Once cashed out, there is no reason for original organization to dedicate itself to continued excellence.  Whatever Intel "product with security enforced by McAfeee" is announced, quickly/eventually becomes diluted to "product with self-provided security."  The need for ownership control is a primal psychological delusion that transcends even society's most competent management teams, or at least compromises their duty of care for other people's (minority shareholder's) money.  Western democracies have the same authority as the monarchies and dictatorships they replaced or condemn, yet the illusion of autonomy, freedom and un-predetermined outcomes legitimizes government and reduces its security costs.

Intel shareholders, by reducing its market price by $0.70, democratically estimated that Intel overpaid for McAfee by about $4B.  If I were an Intel shareholder I would share their frustration, and agree with the approximate overpayment estimate.   Natural Finance  (QSLs prevents this abuse to shareholders by not burdening existing investors with future project decisions.

Getting back to the Intel McAfee relationship, the rational approach (for Intel) would be to identify the narrowest possible McAfee function it desires to control:  Likely some exclusive hardware license to one specific technology, and then negotiate to control that.  Both the security brand value to intel, and its investment value would be maximized.

Tuesday, August 17, 2010

Redefining Commune -- Communal enterprises

A Communal project is typically an equal partnership in  life/ventures/societies.  A commune is traditionally defined as a living project with equal partnership.  I will further redefine communal to drop equal partnership requirement, and mean a legal framework for sharing of liabilities regardless of any hierarchy or individual profit incentives, but with a substantial internal share of profits.   A cooperative is a communal enterprise.

This is considered a draft post for communal equity

A marriage is a commune in every sense of the word, while a family is not because there is no legal requirement for family members to mutually assist each other.  A bank is almost a commune:  A network of branches, investment banking, and capital trading all pool together to mutually back liabilities.  The extent of its communal nature is entirely dependent on the level of performance-based employment and profitability incentives of each unit.  Higher union wages and performance bonuses all increase the communal purity of a bank, even when it fails communal definition by returning the coomon surplus to shareholders.

Natural Finance separates rewards for financial and labour contributions.  Assigns financial benefits to Investor's financial contributions, and purpose-holding benefits (by default, rights to distribute or direct ultimate profits) to labour.  A founder commune in the traditional equality sense is an obvious option.  Another option is allowing corporate/communal officers to democratically reward officer efforts with post-investor benefits.  Natural Finance facilitates several corporate currency instruments (deferred compensation, W, X and Z prizes are all addressed in manifesto).  Using democratic bonuses and deferred compensation, a communal enterprise can satisfy communal definition without equal participation by labour, and without any consideration for financial contribution.

Natural Finance treats sub-projects much like banks treat branches.  A sub-project is financed in the parent enterprise's name usually with a substantial portion as a secured QCSL tied to the project (which have interest and depreciation repaid each month/period).  Queued behind that secured QCSL are any benefits for the project leader(s).  Sub-projects typically have 10% of contributions go towards the queue.

Sub-projects can be very fine grained.  Any unit sales or production function, or any function that performs a measurable output can be made into a sub-project.  Sub-project managers have at least 3 compensation streams.  cash salary, enterprise deferred compensation, and project bonus (y prize).  The default relationship is an employee one.  As a default, the employee contract is re-negotiated (or discontinued0 after the y prize is paid.  Alternate options include giving sub-project managers "equity" stakes, and treating salary cash payments as (5%) advances on future distributions.

A co-operative can be viewed as a collection of sub-projects.  Co-operatives traditionally involve individual resellable ownership rights to definable portions of an asset, together with a democratic share of ownership and liabilities in the whole.  Achieving the same structure through Natural Finance, involves assigning a resellable perpetual right to the sub-project for its manager, rather than employment of the manager.   The communal tightness of each sub-project is flexible.  A joint-venture is a non-communal alternative, and sub-projects can be structured more like joint ventures than a mutual sharing of liabilities.  Ownership is not as key of a feature as joint vested interests in success.  Equality of members is also not critical to a communal definition, though democratic or equality of member opportunities scores many communal points.

Modern incentivised management techniques naturally benefit from shifting purpose-holding away from investors and towards labour and direct stakeholders.  While traditional financial thinking embraces individual rewards, and  has animosity to communal concepts stemming primarily from distant cold-war politics, communal responsibility and purpose has important motivational possibilities including peer-reinforced indoctrination, and when we drop mandated equality, can include traditional incentives for individual effort.

Communal equity principles

Sunday, August 15, 2010

Comptrolling function - verifying trust

Queued Soft Loans are repayable based on ability.  It is important to lenders that whim or choice not determine ability, and important that lenders need not request payment to obtain it.  Comptrollers ensure this in addition to preventing corruption of the enterprise.

Comptrollers are 3rd parties appointed when the enterprise becomes a Natural Finance Comptrolled Organization (NFCO).  The comptroller organization is appointed for "life".  The comptroller organization has control over all enterprise financial accounts.  It must sign off with enterprise officers on every major expense.

The comptroller's authority over future projects and expenses is based only on whether they compromise survivability of the enterprise.  He guards over high, potentially preferential, payments, and ensures that new project funding covers a portion of related ongoing expenses (6 months worth for example).  The strictness of the comptrolling function on management depends entirely on the health and success of the enterprise.  Companies in the startup phase, or with higher debts than assets have tight controls.  No revenue means management cash salaries are at their minimum levels, while they rise to their maximum when operational earnings reach 10% (or natural rate if lower) of outstanding soft loan principal.

NFCOs have 2 distinct stages in their lifetimes.  The transition occurs when secured and unsecured QCSL investors gain certainty of payment.  Defined as the point when all investor QCSL holders are projected to be paid in 5 years.  After the transition point, the focus or primary mandate of the comptroller becomes ensuring that purpose-holders (other than management) have their promises fulfilled.  It is possible for the enterprise to slip below the transition point, in which case the primary comptrolling mandate shifts back to investors.  Purpose holders care about total compensation, as compared to cash compensation that concerns investors.

The investor benefit of comptrolling is the superior certainty that enterprise revenue is diverted to repaying them, together with expense control.  Far superior to management employed auditors.  This is in addition to the certainty in priority of payment of natural finance QCSLs.

The management benefits of submitting to comptroller authority are in attracting investors, paying them less due to lower risks, and having a secure attractive currency with which to influence suppliers, project partners, and with which to influence social groups to become purpose-holders.  The manager gains the freedom to found companies without any out of pocket investment, earns comfortable to high salary when corporation is profitable, and gains ultimate freedom after company passes the transition point.

Maximum management cash salary ($100K) at 10% return to investors is justified in that an enterprise achieving such a return is naturally successful regardless of the market forces determining the natural rate for the enterprise.

Chartered public accountants in their audit role of a corporation differ substantially from Comptrollers.  First, the Agent-Principal problem exists with CPAs.  They are hired by management to project a perception of honesty and solvency to outsiders such as shareholders and tax authorities.  They can be fired if they are unwilling to confirm management's desired perceptions.  Bernie Madoff gave the impression he was audited, for example.  GAAP rules allow auditors leeway in interpreting corporate cashflow optimistically for investor perception, and pessimistically for tax authorities. Comptrollers have authority over the corporation that auditors don't.  There is no corporate right to fire them.  Cash-basis accounting determines all decisions.

Friday, August 13, 2010

The right of taxation vs the right of ownership

Governments hold the right to tax you.  Although most people would find the alternative distasteful, Government's holding a percentage ownership over you is actually a weaker right than the power to tax you.  A Government's passive right to a percentage of dividends you pay yourself is equivalent to the passive rights of a minority shareholder.  Under Modigliani–Miller theory, the government should be passive between the 2 choices.  A company that reinvests what it would otherwise pay in taxes, theoretically grows its accumulated profits more, and so has more funds available to pay investors and government when it pays.  The theoretical time adjusted return to government is identical for a 30% tax rate and a 30% ownership rate.

From the enterprise's point of view, it offers no real new tax avoidance opportunities.  It just greatly simplifies actions.  Instead of depreciating assets over their lives, enterprises simply use the natural cash based effects of their actions, and massively complex accounting rules designed to determine yearly tax obligations are no longer necessary to satisfy government obligations.

From an individual point of view, a government partial ownership would be almost equivalent to a progressive consumption tax:  Simply make all investment tax deductible, but raise progressive tax rates substantially.

The right of taxation vs the right of ownership is roughly comparable to the right of demanding specific regular dividends vs the passive right to claim a proportional amount of dividends when the tax payer decides to pay himself.

Under natural finance, the ideal tax regimes would be to tax salaries, benefits, bonuses, capital gains and dividends a flat 10%, while not taxing interest income.  There would be a progressive tax on total consumption, with a rebate of the 10% (salary/capital) tax for those consuming under, say, $20k/yr.  The reason for not taxing interest income under natural finance is that it is determined by perfect markets, and non discretionary:  If you are earning more interest than you deserve, someone will buy your loan away from you.  All other benefits and compensation are discretionary agreements.  Corporate taxes would be replaced with passive ownership benefits.

Tax rates have no impact on corporate investment

Take an investment opportunity that will either double the investment or lose it all.  We can compare it to a wager, and assume that no fun entertainment value exists in the wager.  We can compare a tax rate to a partner that funds a percentage of our bet, and so will take a percentage of the winnings.  Corporate taxes are such that when you lose, you carry the writeoff to other projects; present, past and future.  So the partner analogy holds approximately if you lose as well.

The only significant consideration in whether you place the wager or not, is your confidence in winning.  Whether your partner's share is 39% or 36% has absolutely no relevance.  It is dishonest for republicans to lie that a 36% tax rate on the "investment class" is going to create jobs and investment compared to a 39% tax rate.

The deficits vs growth debate places too much emphasis on growth.  First, in the short term, if you grow the deficit by $10T to spend on wars and cocaine, you will mathematically directly grow the GDP by at least $10T.   It is a sugar high, with no lasting economic impact.  When you reduce the deficit from year to year, you will cause a reduction in GDP by the amount of the cut.

So deficits directly cause growth.  But it does not cause investment and jobs, especially not when it is made by changes in the top marginal tax rate.  Deficits and a high total debt burden make the confidence of wagering on America very low.  It makes job creation and investment unattractive.  A path to the economic collapse of America is vivid to all.  Made even more vivid by the blatant corruption to ensure collapse by diverting economic sustainability to the greediest wealthy. A vivid path to collapse is directly related to the large debt burden, and there are 2 stark political choices.  Pillage all you can before the inevitable collapse, or prevent it.

A tax rate can be more attractive than a partnership agreement, because you retain control in how and when you pay your partner (assuming the partner doesn't want his cut immediately after each wager).  If you win the wager, you can pay yourself a higher management fee, or spend to make friends and influence people.

Thursday, August 12, 2010

Enforced Ability-based Soft Loans = Natural Finance Soft Loans

Enforced Ability-based Soft Loans is a more technically specific description of natural finance soft loans.

google and wikipedia tell us that Soft Loans have already been defined as:
"a loan with a below-market rate of interest. This is also known as soft financing. Sometimes soft loans provide other concessions to borrowers, such as long repayment periods or interest holidays. Soft loans are usually provided by governments to projects they think are worthwhile. The World Bank and other development institutions provide soft loans to developing countries."
 Enforced Ability-based Soft Loans are loans without fixed date or amount repayment terms, based on the ability to repay, but mandatory repayment when the ability is present.  I could argue hijacking the word "natural loans", on the basis of the natural mathematical efficiency of enforced ability-based soft loans, but it would confuse.

Stock vs Cash Dividend - The 3rd choice

Variable Dividends (or Fixed Yield Dividends) are a cash dividend that is equivalent choice to a fixed fractional stock dividend.  A fixed fractional stock dividend of 1/10th or 1/40th of a share has a variable cash dividend equivalent of 1/11th or 1/41th of the stock's market value.  The cash value of the dividend is variable with the stock price, which makes the dividend yield fixed.  So even if corporations don't pay as high a dividend as shareholders deserve, they can pay more when stock price is doing well, and less when it is doing poorly.  So can afford a higher target payout ratio, and smooth out stock price fluctuations by providing investors with a mechanism to hold low and sell high.

While all investors should be disappointed with management's primacy of self agendas over their contractual mandates, I recognize that there are far greater evils in this world.  Living with the reality of corruption of mandates to shareholder value,  and deceptions to investors regarding shareholder rights, the continued health and capitalization of the corporation does benefit other direct stakeholders (management, employees, customers).  Yet a higher target dividend payout is possible through variable dividends without compromising the health of the company.

A 3rd choice is possible to boost target payout rates much higher.  Issuing a loan option instead of or in addition to the cash dividend option provides a way for the company to issue high dividends without reducing corporate assets at all.  Issuing a loan, retains the same earnings power for the company.  The interest benefit is a shareholder benefit if the loan is issued as a dividend.

A queued soft loan is a superior alternative in every way to a bond loan for both investors and the honest fair-minded corporation.  Soft loans have a certain priority to payment that can not be worsened for investors, and so corporations can benefit from lower financing costs associated with providing a better valued security.

To boost payout the highest, a cash dividend choice need not be offered.  If the company is debt free, then a QSL vs stock dividend choice results in a virtually immediate cash payment to some of the loan dividend choosers.  the company can pay its earnings towards the new QSLs immediately.

To price the QSL dividend choice benefit, the principal amount is equal the cash dividend equivalent to the fixed fractional stock dividend (1/11th stock price if fractional stock dividend is 1/10th of a share).  The interest rate could be bid on, but that requires logistical support.  In healthy public companies, because QSLs guarantee no dilution of payment priority to the loan holder, every loan has an estimated organic (from operations) payment date.  Organic expected payment date can be used to set the Dividend replacing QSL interest rate to match the government bond rates of similar duration, adding a premium of, say, 20 basis points per expected year of repayment.

A high dividend choice not only allows a naturally efficient mechanism to separate shareholders into those that want to determine purpose of the enterprise vs. those that simply want financial benefit from the enterprise, but it also helps expedite purpose-aspirational shareholders to takeover the company without paying market premiums for it, but in a fair way to all other shareholders.  By bidding on dividend increase projects through QSLs, purpose aspirational shareholders encourage the corporation to boost dividend payout even more, and provide the benefit aspirational dividend choosers with cash payments.

A typical target dividend payout ratio for mature healthy public corporations (that pay dividends) is typically 50% of earnings.  It is 75%+ for Canadian Income Trusts.  When Income Trusts have poor performance periods where there payout reaches 100% of income, their market capitalization tends to drop below their book value, and yields go higher than P/Es.  The market is scared of high payout ratios, mostly because of fear that fixed dividends will be reduced rather than the fear that bankruptcy becomes imminent.  A variable dividend can allow the income trust to pay according to target earnings, and can payout 90%-100% of those earnings targets, because when it falls behind, it will naturally drop in stock price, and pay out less.  Their dividends become self adjusting.

Because of the obvious appeal of high dividend corporations, and the announced intentions of industrial icons (Bell Canada) to convert to Income Trust structure, the Canadian Government has effectively banned income trusts starting in 2011.  Variable dividends will allow converted Income trusts and  those corporations that wanted to be income trusts to boost payouts within management agendas.

Wednesday, August 11, 2010

Converting Public Corporations to Natural Finance - Part 1

Part 1 of 2.   This is the basic plan for converting a healthy public corporation.  It is relatively straightforward, offers free choice, but can overpay by not taking full advantage of natural finance principles to bypass the market corruption caused by the price difference between buying 100 shares vs 10M shares.

copied from manifesto.
Converting a public corporation is voluntary by all affected stakeholders. It can be complete, partial, done in stages, and convert bonds, preferred and common shares. Once natural finance conversion has begun, no new bonds or preferred shares can be issued, and common share issues are not recommended..

Bondholders should be given first priority to convert. Secured QCSLs most closely fit the bonds the company considers too expensive for it. If all bondholders converted to unsecured QCSLs, they would all have enhanced security (demand lower yield) by the fact that they are first in line to be paid. Unsecured QCSL conversion for bondholders is essentially a cash redemption of bonds which is sometimes an enterprise right attached to some bonds. Secured QCSLs also offer better security to converting bondholders because in a distressed bankruptcy type scenario, they get theoretically 100% of principal, and they also receive high yields including a non taxable depreciation coupon. Those bondholders that do not convert, continue to have a fixed obligation paid before QCSLs, including principal at maturity, but they lose relative priority in the event of bankruptcy. A net positive to convert. Even when converting to natural financing in a distressed enterprise situation, if the conversion buys a few years survival, bondholders are substantially incentivized to convert. Better value to bondholders through natural finance, means lower borrowing costs to the enterprise.

Preferred shareholders are the only group that are economically-forced to convert in order to keep their relative security and payment regularity. Secured QCSLs match the payment regularity most closely. Non maturing Preferred shares are in fact a scam on its buyers, because the principal is never repaid. The odds that a non-liquor company will eventually (or within 200 years) go bankrupt are over 99.9%. Preferred shares tend not to have sufficient premium over bonds to understand that risk as properly considered. From the enterprise's perspective, paying a pre-profit coupon inflated by the inverse of its untaxed profit rate is equivalent to a preferred coupon. For example, at a 25% tax rate an 8% bond coupon is equivalent after tax to a 6% preferred share coupon (for same maturity date). From the investor perspective, forcing the exchange is forcing a net benefit of additional bond security, and forcing a net benefit is a gift. In most countries, on average, there is an equivalent after tax return to the securities as well. Offering the same optional conversion options to (converted) bondholders after the exchange, provides the same optional choice to preferred shareholders.

Common shares can be converted by either an internal “takeover” bid by management, a partial substantial issuer bid (bid for up to x shares). A company with net assets of 500K, making 100K per year, 10000 shares outstanding, and P/E of 10 has a $100 share price. If half the shares are sold in exchange for QCSLs loans at 10%, then after 8 years (QCSLs are repaid), without any operational improvement by the company, net assets are back to 500K, and the 5000 shares remaining at a P/E of 10 are worth $200. Every rational person who doesn't have direct oversight of management, and therefore cannot vouch for its confidence, would prefer to hold QCSLs (ignoring tax differences) because they are paid faster and more certainly even if the return is the same. From the enterprise perspective, if it can pay less than 10% interest rate (almost certain given profile), then it is net positive to the enterprise and remaining shareholders. Most successful public corporations should be able to achieve natural rates close to “riskless” government bonds (under 5%-6%).

Pensions are a scam/motivational technique on employees designed to keep them needing work. There are tax advantages for both parties, but administration fees and restrictions on cashability are net negatives compared to direct loans/deferred compensation. A pension system can continue under natural financing and invest its assets back into QCSL backed projects, but management may find employees willing to invest more if they provide them with higher returning and more flexible direct deferred compensation.